It hasn’t even been six months since Ben, an astute observer of financial matters, noted that the spread between a 5-year fixed rate mortgage (FRM) and a variable-rate mortgage (VRM) was unusually low and it may be better to buck the conventional wisdom and opt for a fixed-rate mortgage. Not anymore. Fixed-rates have been relatively steady — according to Invis, a mortgage broker, the “best” 5-year rate available currently is 4.09%, just a smidgen higher than the rate reported earlier. But with the credit crisis easing, VRMs have become much cheaper. While the best rate available on a VRM just six months back was Prime plus 0.80%, today Invis is offering VRMs at Prime plus 0.10%.

Canadian Mortgage Trends reported just the other day that BMO has lowered its variable rate to prime and other banks may follow suit. With a spread of 1.75% between a FRM and VRM and the Bank of Canada saying it intends to keep rates level until 2Q-2010, VRMs may once again be poised to deliver savings over FRMs. The usual caveats apply: mortgagees opting for VRM take on the risk of a spike in interest rates in return for the potential to save interest on their mortgage.

Hi CC,

Hope everything’s been going well.

You’re absolutely right that variables now appear more alluring than they have in a while. Not coincidentally, there’s been a noticeable uptick in variable-rate inquiries (at least at our firm) since they hit prime.

The risk factor, of course, is future rates. If the Bank of Canada starts tightening by next summer, even a 2.0-2.5% rate hike might be enough to make many wish they had a 5-year fixed. The BoC dropped 4.25% in 17 months. They can move just as quickly in the other direction if the economy makes a medium-to-strong recovery.

Those willing to take the risk should have solid finances, good credit, sufficient equity, and the ability to absorb a 35%+ payment increase–assuming they don’t set their payments artificially high from the outset. (If you play this game, however, you might do better in a 1-year fixed–for reasons we wrote about this weekend at CMT.)

There are also increasing numbers of people looking at variables with a plan to lock-in before rates head up. That’s a chancy move and I’d guestimate that most people who do it lock in 0.20% to 0.50% too late. Lenders don’t warn people before rates increase so you need to keep a close eye on bond yields and hope your timing is right. Bonds almost always rise before prime does.

Take it easy,

Rob

@ Canadian Mortgage

I’m curious, which Bond yield to look at and where.

Thanks, John.

@Rob: That’s a good point. It might be even better to opt for a 1-year fixed and hope that variable rates will be below prime one year hence.

@John: You can find bond yields on Rob’s site on the left side.

http://www.canadianmortgagetrends.com/

The Bank of Canada’s website is a great source for looking up bond yields across the spectrum:

http://www.bankofcanada.ca/en/rates/bonds.html

First, I’d also echo the cautious tone of Rob’s comments above. Variable rate mortgages are for those who have the solid defences in place to mitigate the downside risk.

RE: the 1-year fixed option, is it correct to say then, for a consumer choosing between a variable rate mortgage today and a variable rate mortgage one year hence –

If you think

a. The prime rate in 1-year will not be higher than today, and

b. Variable rate mortgages in 1-year will be available at a discount to prime then you may save money by opting for a 1-year fixed today?

Conversely, if a) and b) don’t occur (or a strong showing on b) offsetting any increase in a)), then you may not save money by opting for a 1-year fixed?

@Ben: I think it is primarily (b) — Prime minus VRMs may be coming back in a year. Of course, (b) may not happen or VRMs go back to Prime plus, which means opting for a VRM today instead of a 1-year mortgage will turn out to be a good move.

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@John: One site I like for watching bond yields is Bloomberg. They track the following maturities…

1-year: http://www.bloomberg.com/apps/quote?ticker=GCAN12M%3AIND

2-year: http://www.bloomberg.com/apps/quote?ticker=GCAN2YR%3AIND

5-year: http://www.bloomberg.com/apps/quote?ticker=GCAN5YR%3AIND

10-year: http://www.bloomberg.com/apps/quote?ticker=GCAN10YR%3AIND

There’s lot’s of risks to being a bond watcher though (like fakeouts). So it’s not the world’s best course of action for the average homeowner.

Cheers,

Rob

@Ben: If one assumes a 80%+ chance (just an estimate) of no further credit shocks next year–and hence no variable-rate premiums–then a 1-year is a good calculated bet.

The risk: Short-term rates soar and we head back up to prime + 0.75% or so for a few quarters….and then back down.

The likely best case is that you save 1/4% or so in years 2-5.

This is, of course, a very simplistic and generalized overview. Folks should always talk over their specific situation with someone that can give one-on-one professional feedback.

Cheers,

Rob

Thanks Canadian Mortgage. I guess there is a lot more to this than just looking at ups and downs, like for what period etc… I don’t see myself becoming a bond watcher yet but thanks for the “taste”.

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My thoughts are always go variable, but if in doubt split the mortgage into two parts one variable one fixed.

The economy is better with all the government money spent after that who knows? If rates go up too fast then the V recovery will be a W or maybe a L.

I always go variable, and have the payment = the 5 year rate. You were prepared to make a payment based on a (x) year mortgage anyway.

If your institution doesn’t allow that then go variable and shuffle the savings into a separate account. Every six months or so make a “double up” payment.

P.S if you still want to lock in and pay higher interest, please choose BMO or BNS for your mortgage so that your money will be transferred to my broker account via dividends.

This is how i chose variable when i got my mortgage in May 2008..

I was offered prime minus 0.95 (Prime was 3.75)

I went on BOC website and took prime for last 10 years and discounted it by 0.95 for the 10 years and calculated interest for the 10 years on my mortgage amount.

Did the same with fixed for 10 years (actually i was only offered 5 year fixed at 5.2%).

Guess what my variable came out slightly better than fixed.

At that time i didn;t anticipate any upward interest rate movement so choose to take the difference of 2.3% interest as a big advantage.. For my 200K morgage on a annual basis it was working out to 4600$ per year..

Guess what the interest rates went down to the tank and not the advantage has grown to 8000$ per year.

Variable interest will always win..

No way interest rates can go up above 5% prime with out killing the housing market and destroying the economy

Hopefully banks remember to bring back the good old prime minus days..

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